How the government varies the borrowing between these two categories has an important effect on the level (and distribution) of spending in the economy. The issue of Treasury Bills increases the liquidity base' of the banking system, enabling it to make more credit available (i.e. it increases the MONEY SUPPLY and thus raises spending in the economy); by contrast, the issue of bonds reduces the liquidity base of the banking system as buyers of bonds run down their bank deposits to purchase them (i.e. it reduces the money supply and availability of credit, serving to decrease spending in the economy). See ECONOMIC POLICY, FISCAL POLICY, MONETARY POLICY.

The size of the nominal public sector borrowing requirement depends not only on the government's fundamental spending and taxation plans (its underlying FISCAL STANCE) but also on the level of economic activity and the rate of inflation.

Fluctuations in economic activity lead to movements in the PSBR, for the PSBR tends to increase in a recession as total tax revenues fall and social security payments rise in response to lower incomes and higher unemployment, and to fall in a boom as tax revenues rise and social security payments fall in response to higher incomes and lower unemployment (see AUTOMATIC ( BUILT-IN) STABILIZERS). In order to remove the impact of cyclical fluctuations in economic activity associated with BUSINESS CYCLES upon the PSBR, it is necessary to calculate the cyclically adjusted PSBR. By removing from the PSBR figure the effect of cyclical variations on the budget balance, the cyclically adjusted PSBR measures what the PSBR would be if economic activity levels were ‘on trend’.

INFLATION also has an effect on the nominal PSBR, because since most public sector debt is denominated in nominal terms, its real value falls with the rate of inflation, reducing the real value of the government's liabilities. The real PSBR is defined as the actual PSBR less the erosion by inflation of the real value of the stock of public-sector debt (inflation-adjusted PSBR), so, for a given real PSBR, a higher rate of inflation implies a higher nominal PSBR. When the effects of the inflation rates of the 1970s are allowed for, the high nominal PSBR figures (indicating a large fiscal deficit) show a modest real PSBR (indicating a fiscal surplus). The public sector has been adding to its nominal stock of debt at a slower rate than that at which inflation has been eroding the value of past borrowing.

There are three main ways in which a government can finance its borrowing requirement:

by borrowing funds from individuals, firms and financial institutions in the private sector by selling government bonds and bills. This requires high interest rates to make government debt attractive to lenders;

by borrowing funds from overseas lenders by selling government securities. This overseas borrowing has effects on the balance of payments;

by borrowing short-term from the commercial banking system by issuing Treasury bills to them. This has the effect of increasing the banks’ reserve assets, allowing them in turn to expand their lending.

The first two methods of financing the public sector borrowing requirement by selling bonds to the nonbank private sector are likely to raise interest rates, but because they provide stable (generally long-term) funding for government borrowing they do not affect the MONEY SUPPLY. By contrast, to the extent that the government cannot fund all its borrowing needs from the first two sources, it must resort to borrowing from the banking system. This is akin to printing additional money and serves to increase the money supply.

Public sector borrowing may contribute to ‘crowding out’ (see CROWDING-OUT EFFECTS) the private sector in two main ways. First, by facilitating larger government expenditure, it may cause real crowding out as the public sector uses more of the nation's resources, leaving fewer for private consumption spending and investment and for exports. Second, the additional borrowing by government will tend to raise interest rates, thereby causing financial crowding out as private investment is discouraged by the high interest rates.

In the 1980s and early 1990s, the UK government operated a MEDIUM-TERM FINANCIAL STRATEGY that laid down targets each year for the public sector borrowing requirement expressed as a percentage of GROSS DOMESTIC PRODUCT (GDP). In more recent times, the government has accepted that ‘fiscal stability’ is crucial to maintaining low inflation and that low inflation is essential in achieving low UNEMPLOYMENT. In 1997 the government set an inflation ‘target’ of an increase in the RETAIL PRICE INDEX (RPI) of no more than 21/2% and ceded the power to set interest rates to a new body, the MONETARY POLICY COMMITTEE. Fiscal stability has found expression in the government's acceptance of the European Union's MAASTRICHT TREATY limits of a current budget deficit of no more than 3% of GDP (and an outstanding total debt limit of 60% of GDP) as a necessary adjunct to avoid excessive monetary creation of the kind that has fuelled previous runaway inflations. In fact, the government has gone further than this in adopting the so-called ‘golden rule’, which requires that the government should ‘aim for an overall budget surplus over the economic cycle (defined as 1998/99 to 2003/04)‘, with some of the proceeds being used to pay off government debt to reduce outstanding debt eventually to 40% of GDP (see BUDGET ( GOVERNMENT)) Fig. 18). Along the way, it has introduced more rigorous standards for approving increases in public spending, in particular the ‘sustainable investment rule’, which stipulates that the government should borrow only to finance capital investment and not to pay for general spending. In addition, the government has announced it will ‘ring-fence’ increases in particular tax receipts to be used only for funding specific activities. For example, receipts from future increases in fuel taxes and tobacco taxes will be spent, respectively, only on road-building programmes and the National Health Service.

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